Management Guidance Pre‐ and Post‐Restatement

• Published date: 01 September 2014
• Author: Lili Sun,Elizabeth A. Gordon,Elaine Henry,Xudong Li
• Date: 01 September 2014
• DOI: http://doi.org/10.1111/jbfa.12080

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 41(7) & (8), 867–892, September/October 2014, 0306-686X

doi: 10.1111/jbfa.12080

Management Guidance Pre- and

Post-Restatement

ELIZABETH A. GORDON,ELAINE HENRY,XUDONG LIANDLILI SUN*

Abstract: We examine whether the quality of restating firms’ management guidance differs

in periods before and after restatement announcements. While characteristics of restating firms

and the consequences of restatement have been a central topic in accounting and auditing

research, the quality of management guidance around restatements is less well understood.

We consider two competing characterizations of the link between management forecast

accuracy and bias and restatement (an event that tends to signal poor financial controls):

“Forecast–Opportunism Explanation” and “Forecast–Ability Explanation”. Under the Forecast–

Opportunism Explanation, pre-restatement weaknesses in financial controls enable managers to

manipulate earnings toward forecasts and to meet or exceed opportunistically biased forecasts,

and the post-restatement strengthening of financial controls constrains opportunistic behavior.

Under the Forecast–Ability Explanation, pre-restatement weaknesses in financial controls im-

pede managers’ ability to issue accurate forecasts, and post-restatement improvements remove

impediments so that the accuracy of forecasts improves; forecast bias remains unaffected.

Evidence indicates that before a restatement, restating firms’ forecasts are more accurate and

relatively more downwardly biased than control firms’ forecasts. Post-restatement, restating firms

have less accurate and less downwardly biased management guidance. Our overall results are

consistent with the Forecast–Opportunism Explanation.

Keywords: restatement, management guidance, financial controls

1. INTRODUCTION

This study compares the accuracy and bias of management forecasts pre- and post-

restatement. The objective is to provide evidence on whether and how a deficient

reporting environment, evidenced by a subsequent restatement, relates to the quality

of management guidance. While characteristics of restating firms and the conse-

quences of restatement have been a central topic in accounting and auditing research,

the quality of management guidance around restatements is less well understood.

*The first author is from Temple University, 453 Alter Hall, 1801 Liacouras Walk, Philadelphia, PA 19122.

The second author is from Fordham University, Gabelli School of Business, 441 East Fordham Road, Bronx,

NY 10458. The third author is from Monmouth University, Leon Hess Business School, 400 Cedar Ave,West

Long Branch, NJ 07764. The fourth author is from University of North Texas, 1155 Union Circle #305219,

Denton, Texas 76203. The authors would like to thank Martin Walker (Editor) and an anonymous referee

for insightful comments that significantly improved the paper.

Address for correspondence: Lili Sun, University of North Texas,1155 Union Circle #305219, Denton, Texas

76203.

e-mail: Lili.sun@unt.edu

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868 GORDON, HENRY, LI AND SUN

Management guidance is an important voluntary disclosure in which managers

communicate expectations, thus reducing information asymmetry (Ajinkya and Gift,

1984; Coller and Yohn, 1997). We address the following research questions: Prior

to a restatement announcement, do accuracy and bias of management forecasts of

restating firms differ from those of non-restating peers? Following a restatement

announcement, do accuracy and bias of management forecasts differ between the two

groups? Finally, does the change in accuracy and bias of management forecasts for

restating firms from pre- to post-restatement periods differ from that of non-restating

firms over the same time period?

Accuracy is generally accepted as an attribute of high quality forecasts (e.g., Baginski

et al., 1993; Hirst et al., 2008; Williams, 1996). Unlike forecast accuracy, the desirability

of unbiased management forecasts is more ambiguous. Arguably, forecasts that are

accurate and un-biased (neither upwardly nor downwardly biased) are most desirable;

however, the market typically rewards firms when actual results meet or exceed

analysts’ expectations, and analysts’ expectations are shaped by management guidance

(Matsumoto, 2002; Richardson et al., 2004; Cotter et al., 2006; Keskek et al., 2013).

Downwardly biased forecasts are more likely to be exceeded and thus rewarded.

Our analysis is based on the assumptions that weak financial controls often exist

prior to restatements and that, following restatements, improvements in financial

controls are likely to occur as firms seek to mitigate the costs of having issued a

restatement.1Such costs include a higher cost of capital (Hribar and Jenkins, 2004;

Kravet and Shevlin, 2010), lower perceived information content of earnings (Wilson,

2008), and management reputation damage (Desai et al., 2006).

In our examination of management guidance prior to a restatement (the period

probably associated with weak controls) and following a restatement (the period prob-

ably associated with improved controls), we consider two competing characterizations:

the “Forecast–Opportunism Explanation” and the “Forecast–Ability Explanation”.2

Under the Forecast–Opportunism Explanation, pre-restatement weakness in financial

controls enables managers to behave opportunistically, and post-restatement strength-

ening of financial controls constrains opportunistic behavior. This explanation is

supported by studies that document poor financial reporting quality in the presence

of control weaknesses (Doyle et al., 2007) and earnings management to “meet

or beat” forecasts (Burgstahler and Eames, 2006; DeGeorge et al., 1999; Graham

et. al., 2005; Payne and Robb, 2000). If the Forecast–Opportunism Explanation

applies, then we expect more accurate forecasts before the restatement because

weaknesses in financial controls enable managers to manipulate earnings toward

forecasts. We also expect more downwardly biased forecasts before the restatement

1 We view “financial controls” as broadly the entire set of processes employed by management, the board,

and auditors to ensure high quality financial reporting. It should be noted, however,that improved financial

controls are not the only mechanism by which management’s incentives to behave opportunistically could be

constrained post-restatement; in addition, an increased probability of costly litigation or increased external

scrutiny could also serve as constraints on such behavior.

2 The two alternative explanations are deliberately stylized and meant to capture defining characteristics

of the link between management guidance and financial controls, pre- and post-restatement. We do not

intend to imply that the alternatives are strictly mutually exclusive inasmuch as a given firm could have

attributes of both. For example, pre-restatement, a given manager might have the inability to accurately

forecast performance and thus may opportunistically manipulate earnings to falsely portray accuracy, and

then post-restatement improvements in forecast ability could eliminate the need to manipulate earnings

for that purpose. The empirical results we observe in the overall sample are the net joint effect of both

explanations.

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